The Great Baupost Madoff Claim Trade That Made A Big Madoff Feeder Fund A Loser Again

In the summer of 2010, James Mooney, a partner at Baupost Group, the massive $24 billion Boston hedge fund run by investment legend Seth Klarman, sensed there was money to be made acquiring customer claims of Bernard Madoff’s bogus investment firm. Mooney believed the Madoff claims represented a classic distressed debt situation, where “sophisticated participants in the market” who were “aided by their advisors, such as legal counsel,” could better understand the complex dynamics at play, according to a court-filed declaration Mooney made last year.

In particular, Mooney thought it was possible that Irving Picard, the court-appointed trustee of Madoff’s investment firm, could reach a favorable settlement with Barbara Picower, whose late husband, Jeffry, had extracted $7.2 billion from Madoff’s Ponzi scheme before it collapsed. Mooney also felt it was very possible that the trustee’s net equity process of reimbursing Madoff’s Ponzi scheme victims would survive court challenges. All Baupost needed was to find someone willing to trade their Madoff claim at the right price.

Baupost found that trading partner in the British Virgin Islands and now the hedge fund is currently sitting on a fat estimated return of 116%--although it still needs to finish getting through a long legal fight over the trade.

As it happened, Kenneth Krys, the British Virgin Islands-based co-liquidator of the biggest Madoff feeder fund, Fairfield Sentry, had a Bernard L. Madoff Investment Securities claim with a face value of $230 million that in 2010 he wanted to sell. Operating through a Delaware affiliate called Farnum Place, Baupost started negotiating with Krys, submitting a bid to pay 32.125%, or $74 million, for the $230 million claim. Krys accepted Farnum Place’s offer, believing it “was in the best interest of the estate of Sentry,” court documents show, and signed off on the trade in early December 2010.

Three days later, Picard, the Madoff firm’s trustee, announced that he had cut a $7.2 billion deal with Barbara Picower, which called for $5 billion to be paid to the trustee. As a result, Picard had dramatically increased the amount of money he would have available to pay back victims of Madoff’s fraud—those who invested directly in the Madoff firm and took out less than they put in—to $8.7 billion.

Within days, Madoff investment firm claims were changing hands for as much as 60 cents on the dollar. Very quickly, Baupost’s $74 million investment was worth $138 million. Today the claim Baupost purchased is worth about $160 million or so. “The Picower settlement amount,” said Krys in a court document, “was far in excess of what I generally understood to be the potential liability of Mr. Picower’s estate.”

This was a bad trade for Krys, who because of it now has much less money to pay back victims who invested in the Madoff Ponzi scheme through the Fairfield Sentry feeders. The Madoff claim he traded to Baupost was the feeder fund’s primary asset. Indeed, in a complicated deal Krys reached with Picard, Fairfield Sentry had agreed to pay $70 million to Picard for the claim to be allowed in full. It might have looked like a smart risk-management move, but it seems like investors in Fairfield Sentry are almost destined to endure catastrophic investment management.

Krys hoped to make up for this mistake by trying to get a British Virgin Islands court to negate the trade with Baupost. As a federal bankruptcy judge in Manhattan recently put it, “disheartened by his bad luck, (the Fairfield Sentry liquidator) scrambled to undo the sale by any means necessary.” Last year, however, the British Virgin Islands court held the trade was valid.

Next, Krys tried to get a U.S. judge to undo the trade, dragging Baupost through the U.S. court system, where Baupost’s connection to Farnum Place and its ultimate role behind the trade came to light. But last week federal bankruptcy judge Burton Lifland denied Krys’ effort, saying: “This is a pure and simple case of seller’s remorse.”

Baupost declined to comment. For his part, Krys may not be ready to give up even though two courts have now essentially ruled the trade was fair and square. “An appeal of the decision is being considered,” he says in a brief statement.

I am a senior editor at Forbes who likes digging into Wall Street, hedge funds and private equity firms, looking for both the good and the bad. I also focus on the intersection of business and the law.